Published: January 14, 2013 at 5:01 pm

Small-cap and mid-cap stocks are the source of much of a hedge fund’s alpha, as these stocks are less covered by the media and other large investors and therefore are more likely to be inefficiently priced. As a result a hedge fund’s research team is more likely to uncover value when evaluating companies with market caps under $5 billion, and so it’s not surprising that on average stocks in this valuation range that hedge funds buy tend to perform particularly well. We’ve estimated that the most popular small cap picks among hedge funds have an alpha of about 120 basis points per month (read more about our hedge fund small cap strategy).

Our small-cap investing strategy, with picks revealed in our August newsletter, returned 14% between September and December- we don’t expect to do quite that well in the future, but it does demonstrate that these stocks can be good values. Here are five stocks with market capitalizations between $1 billion and $5 billion that billionaire James Dinan’s York Capital Management reported owning in its most recent 13F filing (see the full list of Dinan’s stock picks):

York initiated a position of 1.3 million shares in Dun & Bradstreet Corp (NYSE:DNB), making the (currently $3.6 billion market cap) information and risk management company one of its five largest stock positions. At 13 times trailing earnings, Dun & Bradstreet has at least some value potential; its earnings were up strongly in its most recent quarterly report versus a year earlier, though revenue was actually down slightly. We would note that it is a fairly popular short, so a number of other traders consider it overvalued. Chieftain Capital, managed by John Shapiro, owned 2.2 million shares at the end of September (find Chieftain’s favorite stocks).

Another stock on the fund’s top ten list was The Manitowoc Company, Inc. (NYSE:MTW). As primarily a provider of cranes and related equipment, Manitowoc is tied closely to construction activity and the stock has a very high beta of 3.7. As a result investors should be at least somewhat optimistic on the U.S. economy before considering buying. The trailing P/E is 26, but sell-side analysts think that this year will be much better and so the multiple based on 2013 consensus earnings is only 12. Malcolm Fairbairn’s Ascend Capital was also buying the stock.

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